Economy

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As tenants face the challenge of paying rents, building owners, particularly those with hard-hit retail spaces, have had to consider options in order to cover their own costs. These include property taxes that have soared over the years in major cities. The owners with mortgages are in a particularly challenging spot.

“Those with tenants in financial crisis typically want to ensure the businesses were in good shape prior to the pandemic, that the businesses truly need help and that tenants have looked into claims for business interruption insurance, as well as government stimulus programs.”

“Property tax is probably the largest component of rent that the tenant has to pay and municipalities typically aren’t abating property taxes. So, the landlord is still faced with the property tax bill they have to pay and the mortgage obviously.”

“There’s the added complication that if an owner wants to defer or lower rents, they have to check with their lender, or it could be a breach of their mortgage agreement.”

The capitalization rate of a real estate investment is calculated by dividing the property’s net operating income by the current market value. It’s the most popular measure for how real estate investments are assessed for profitability and rate of return.

Our expectation is that they will start to go up, because people are going to start to see more risks. The days of looking at an asset and painting it with a broad brush . . . are evaporating.

However the greatest factor for cap rates universally is the strength of a landlord’s tenants to pay their rent.

How will the recession brought about by government measures to combat COVID-19 impact commercial real estate valuations?

While it’s still too early to know long-term repercussions, companies are currently carrying out stress tests, forecasts, analyses and covenant-checks of assets to try to avoid surprises later.

Theoretically, property values should be moving lower as risks have increased and cash flow has likely weakened. However, as long as companies and high-net-worth investors seek to deploy large amounts of capital to buy real estate, the trend of high property valuations could continue.

Retail valuations

The retail sector has been challenged in recent years

While trophy assets such as CF Toronto Eaton Centre and Yorkdale Shopping Centre should still be very strong, there will be a widening gap between good and bad malls.

Enclosed malls in secondary and tertiary markets that were already ripe for redevelopment opportunities may have those plans hastened.

Grocery and pharmacy-anchored retail strips have generally performed well, as those stores have remained open to provide essential goods. However, those locations often also feature small businesses such as salons, bakeries and dry cleaners that may be in for tough times.

Migration to online shopping isn’t likely to end.

Multifamily

“Multifamily real estate has historically been the most resilient asset class and we think that continues today,” said Anna Kennedy, chief operating officer of KingSett Capital, a private equity real estate firm with $13 billion of assets under management.

Kennedy cited low vacancy rates, upward pressure on rents and an existing need for more rental apartments in key Canadian urban markets, which she believes portend continued strong performance.

Sender said people who are renting typically don’t have a lot of alternatives, and need to live somewhere, so “it makes sense that multifamily will be more resilient than commercial asset classes.”

Office

The majority of office workers across Canada have been working from home for about two months, and Kennedy said it’s been “quite remarkable” how they’ve adapted.

However, the consensus of the panel members was people still long for human interaction, working in teams and innovating, as well as creating new business relationships instead of just maintaining existing ones. All of this can best be done in office environments.

“If anything, they may well need more space because they’re concerned about the higher densities in their office space,” said Kennedy.

Increased workplace flexibility through hoteling systems and having more people work from home, at least part-time, could reduce demand for office space. However, Johnston believes it will be balanced by the desire for increased buffering and distancing.

Calgary office

While the office markets in most major Canadian cities have performed well of late, Calgary was a glaring exception. The most recent collapse of oil and gas prices has exacerbated the problems there.

Johnston said Altus was seeing light at the end of the tunnel with absorption and had forecast rental growth for the next few years, but that will now be amended.

Long-term leases signed years ago now have rents well above market value, and rents have decreased dramatically upon lease rollovers, according to Johnston. With Calgary’s downtown office vacancy rate hitting 24.6 per cent in Q1 2020, and expected to rise, rents should continue to decline.

One note of optimism was expressed by Kennedy. KingSett has four per cent of its income fund invested in Calgary and owns a couple of office buildings there that have “already been written down substantially over the last four years.”

She said rent collection for April was more than 90 per cent.

Seniors housing

Johnston said Altus was doing a lot of feasibility work for companies interested in building more seniors housing, which had been acknowledged as a growth sector because of Canada’s aging population.

The large COVID-19 death tolls in seniors homes has likely put a pause on that. Down the road, however, there will continue to be a need for such facilities — albeit with increased staffing, cleaning, security and other improvements.

“It’s not all seniors housing that’s being hit hard,” said Chin. “It’s long-term care which is the most vulnerable.”

Johnston said the children of seniors often decide if their parents will go into these facilities. Their personal wealth has potentially been decreased in this pandemic-caused recession and they may no longer be able to afford to pay for it.

Industrial

Johnston believes the industrial sector should remain relatively unscathed and companies will want to build more if they can find the land. Industrial space close to cities will continue to be especially important for last-mile delivery of goods.

Small-bay properties may be challenged, depending on where they fit in the supply chain, according to Johnston.

Chin said supply chain issues might prompt some companies to stockpile certain goods to ensure availability, and places will be needed to store them.

“We’ve lost some of our confidence in relying on global supply chains,” said Kennedy. “I think we may bite the bullet and pay more for certain strategic goods that we may want to manufacture at home.”

Hotels

Hotels will get “kicked in the teeth the hardest,” according to Sender, who believes the asset class is “in for a tough go for a period of time.”

Johnston said tourist-oriented hotels will suffer because people may be wary of going to them, travel may continue to be restricted to some extent, and disposable income could be impacted over the next few years.

Downtown hotels in major cities catering to diverse clientele – business clients as well as vacationers – may recover more quickly.

Development

Some new development has been temporarily put on hold due to COVID-19-mandated construction stoppages or slowdowns, which is likely to impact project budgets. Chin said the primary issue with development is delayed registrations because of municipal offices being closed.

Johnston said Altus is still performing development appraisals, however, and it’s too early to say if land values have been negatively impacted.

Although Otera is being conservative with its loan structures, Chin said the company is “looking at new development on a very selective basis. It depends on who the sponsors are.”

Otera has been repaid on three large condominium loans through the COVID-19 crisis and Chin expects to be repaid on two more in the next month, which are positive signs.

Canada’s oil industry is fighting for its life. In 2014, a barrel of crude sold for US$100-plus. This week, supply and demand got so distorted that people literally had to be paid to take a barrel of oil.

Oil’s decline is a mega-trend that will directly or indirectly affect Canadians for decades to come. It will even affect the price we pay for mortgages.

History has shown that variable and short-term mortgages outperform longer fixed terms. The dis-inflationary effect of oil’s slow demise could weigh on rates and reinforce that trend.

A SIDELINED BANK OF CANADA

There will be “no increase in [Bank of Canada] policy rates until at least 2023,” Mr. Brown projects. And a similar chorus echos throughout economist-land.

All else being equal, the economic drag from a contracting oil sector could exert downward pressure on rates for more than a decade, past the end of the COVID-19 crisis.

LOWER BORROWING COSTS

Calamity in the oil patch and general economic devastation are nothing to celebrate. They’re tragic. But if they’re going to happen, one should at least capitalize on one silver lining: lower borrowing costs.

During this time of financial disruption people are and should be seeking to shore up their financial position, just as businesses are looking for ways to strengthen their Balance Sheet.

A popular option in the past has been to refinance homes to either take advantage of lower interest rates or to pull out equity as a source of extra funds. But in an unprecedented situation like the one we’re now dealing with, the refinancing landscape can look quite different than it has in a long while.

Here is some information from the article I will provide a link to at the bottom of this post.

“Does the option to refinance property work the same for me today?The short answer: It depends. Everyone’s situation and circumstances are different, but qualifying is not as easy as it was before. In the wake of the COVID-19, refinances have been tougher for Canadians for a few reasons.”

Due to declining employment, lenders are more wary when it comes qualifying income. With record job losses in March and the grim outlook of Canada’s future unemployment rate, lenders are digging deeper into current employment status and the stability of future income.

If a borrower is self-employed they may also need to provide a description of their business, its current status, and reasonable proof that it can withstand the effects that will come with COVID-19. In addition, lenders will not use any temporary government benefits towards qualifiable income, but they recently started considering Child Tax Benefit as qualifiable income, which can be very helpful.

While private lenders are also being cautious by lowering LTV ratios or requiring interest pre-paid for all or part of the term, they are also providing much needed solutions to buyers and homeowners during this difficult time.”

The decision-making criteria for Canadian Homeowners on this is quite clear

If you think you may want or need to have access to more capital in the coming months or years, then get it done now, as it appears that financing will continue to become tougher to get as time goes on. Remember, once it’s too late…it’s too late.

I have followed CIBC World Markets Managing Director and Deputy Chief Economist Benjamin Tal for nearly 20 years. He has a solid track record. He’s what he’s saying about what to expect going forward in 2020 and beyond.

On the Economy:

Multifamily, office and industrial real estate will emerge from the COVID-19 crisis as winners, while losers will include the energy, transportation and hospitality sectors.

“It’s not a recession, it’s not a depression, it’s something in-between. It’s basically a frozen economy.”

Tal anticipates governments continuing to play a large role in the economy, as relief payments to get people through the crisis evolve into a more permanent universal basic income system.

Many companies will start thinking less in terms of profits and more in terms of resiliency.

More medical-related products and other essential goods will be produced domestically and there will be a move from “just-in-time” to “just-in-case” inventory systems.

On Real Estate:

Tal said real estate valuations being made now have very little value and people should be careful about making decisions based on the current economic situation. “I think the damage to the real estate market isn’t as significant as perceived.” Tal expects the Canadian economy to emerge from the recovery phase in 2022 or 2023 and that “the demand for real estate will remain very strong.”

The Canadian rental housing market is not in danger of collapse. Tal said the rent payment rate among those low-income earners was higher than for Canadian renters in higher income brackets. He attributes this to many low-earners now receiving a $500 weekly Canada Emergency Response Benefit payment from the federal government, which they’re using to pay rent.

The number of immigrants and non-permanent residents in Canada will decrease this year. A large percentage of those people are also renters, which will decrease demand for rental housing. Tal expects that to be balanced out somewhat by a reduction in supply due to a lack of apartment building completions, so the vacancy rate increase won’t be dramatic.

Commercial real estate sectors:

“But at the same time, I think that those who predicted that this market will collapse are overstating the damage. I don’t think that the move towards people working from home will be as dramatic as perceived, given the productivity aspect.”

“High-quality retail will remain in demand, and in fact it will improve,” said Tal. “I see significant damage to low-quality retail. This means that you will see e-commerce taking over.”

Credit Union customers – access to a variety of programs and solutions designed to ease difficulties with loan payments and short-term cash flow. Check with your Credit Union.

Important note – a payment deferral is not a forgiveness of the amount owed. It means the payments are deferred to a later time, when we will have to pay them back, plus the cost of interest charges on the interest deferred.

CERB will give workers who cease working or are receiving reduced employment income because of COVID-19 $500 per week for 16 weeks. The income will be taxable, but the gov’t will not deduct income tax at source.

As a Canadian employer whose business has been affected by COVID-19, you may be eligible for a subsidy of 75% of employee wages for up to 12 weeks, retroactive from March 15, 2020, to June 6, 2020.

This wage subsidy will enable you to re-hire workers previously laid off as a result of COVID-19, help prevent further job losses, and better position you to resume normal operations following the crisis.CEWS details previously published:

CEWS provides a wage subsidy of 75% up to a maximum salary of $58,700 ($847 per week) for up to 12 weeks.

It is available to all Canadian businesses that experience a 15% revenue reduction in March and 30% reduction in April and May (compared to either 2019 figures or 2020 figures), or to an average of their revenue earned in January and February 2020. There is no overall limit on the subsidy amount that an eligible employer may claim.

The subsidy is retroactive to March 15, 2020.

Businesses may measure revenue on the basis of accrual accounting (as they are earned) or cash accounting (as they are received); once a method is selected, it must continue to be used.

Once an employer is found eligible for a specific period, they will automatically qualify for the next period of the program.

The CEWS will provide an additional amount to compensate employers for their contributions to the Canada Pension Plan, Employment Insurance, Quebec Pension Plan and Quebec Parental Insurance Plan paid in respect of eligible employees who are on leave with pay due to COVID-19.

The employer will be required to repay amounts paid under the CEWS if they do not meet the eligibility requirements.

Enhanced Canada Child Benefit for the 2019-2020 benefit year, by $300 per child

GST Credit increase

A one-time special payment by early May 2020 through the Goods and Services Tax credit. The average boost to income for those benefitting from this measure will be close to $400 for single individuals and close to $600 for couples.

Delay to Income Tax filing deadline to June 1, 2020 and payment deadline to Aug 31, 2020

These you must Apply for:

EI Work Sharing Program

Federal Student loan 6-month payment moratorium. Note: this is a deferment, not a forgiveness.

Context – Let’s first look at the key elements and actions driving interest rates and economic activity right now

Liquidity crisis

Remember 2008. The capital markets dried up and the huge gaps had to be filled. Now is similar but with an entirely non-economic cause.

“The Bank of Canada (BoC) is meeting twice a week with the senior leadership of the Big-Six Banks. The cost of funds for the banks has risen sharply. CMHC is buying large volumes of mortgages from the banks, which, along with CMB purchases by the central bank, will shore up liquidity.” Dr. Sherry Cooper of DLC

CMHC has acted to provide liquidity for the Banks by buying large tranches of mortgages and has bumped the quantity of those purchases once already. This frees up lending capacity for the banks by returning the cash to their balance sheets.

The Federal Government has acted to provide liquidity for businesses by way of loans, tax and other deferrals

The Federal Government has announced a new program, the Canada Emergency Wage Subsidy (CEWS) program which is to provide to companies that have a 30% loss of revenue up to a 75% wage subsidy to help Businesses keep & return workers to payroll retroactive to March 15. The initial announcement indicated that payments will be capped at 75% of $58,700 an employee’s annual income, so $1,129 per week for up to 12 weeks (again these are the initial indications, yet to be fully unveiled, because, well they’re more than likely not yet fully decided).

The Federal government has acted to provide liquidity for individuals with several programs, the largest being the $2,000 monthly to all with COVID-related loss of income.

Bank of Canada has acted to provide liquidity for businesses and individuals by lowering the Overnight Target Rate 3 times in 10 days, a total of 1.50%. Biggest and fastest cuts ever.

Commercial financing is largely frozen right now.

Paradox – the Prime rate has dropped by 1.50% in the last 2 weeks, but mortgage rates are going up

Hi-ratio insured mortgage rates are lower than uninsured rates. That is counter-intuitive to the inherent relative risks and is due to mortgage regulatory changes of recent years.

Variable rates are down by 1.50%, but the discounts to Prime have nearly disappeared.

Hi ratio insured from Prime less 1.0% or better, to Prime less 0.2% at best.

Uninsured from Prime less 0.5% or better, to Prime less 0.0% at best.

Fixed rates are wildly gyrating, the first increases ~2 weeks ago was about increasing spreads on banks cost of money. Since then it is supply and demand, due to reduced staffing levels, massive inflow of mortgage payment deferrals calls, and huge volumes of applications (now dropping).

Due to the above: Fixed rates are up ~0.50% over the last week, a bit less for hi-ratio insured mortgages, after dropping initially when the Bond market yields crashed.

“What happens when lenders worry about mid-term and long-term lending? Then you have no market”

“How long can Central Banks keep interest rates low when increasing risk demands that they rise? It’s like loading a spring. Will it take 1 month, 12 months, 18 months? No-one knows, but the risk is there.”

What happens if Canada’s government takes on so much debt that institutional and international investors who buy those bonds begin to demand higher, perhaps much higher, returns on those bonds. And if the same occurs in most of the rest of the developed world it seems to me the impact of that would be a scarcity of capital. These things would yield increased inflation and in turn higher interest rates for Canadians. See the below chart of the Government of Canada 5-year Bond yields from 2000 to March 30, 2020. How far yields have fallen. These have been an extraordinary last 20 years, especially the last 12 since 2008.

What to expect over the next 90-180 days

Variable Rate Mortgages: discounts to the Banks’ Prime Rates: Have all-but disappeared, and I don’t see that changing in the short term. I suspect those discounts should return somewhat close to previous levels once the economy is up and running to a reasonable level.

Fixed Rate Mortgages: I believe should come back down as the Bond markets settle – BUT – that might not happen, depending on how much higher the costs of supporting Canadian economy goes. And it could go up significantly.

Note- as my friend Jeff Gunther said on a call today “when rates move they move quickly”. And I would add sometimes “also by a lot”.

Lenders will reduce LTV limits in various markets. Some lenders will (and already have) vacate various markets and/or various products lines. One Monoline is out of the Prairies, another is out of both insured and uninsured lending in the Prairies, and two more are already out of uninsured lending in Alberta. This is driven by investors backing away from perceived risks, and by Monoline lenders’ volume capacities due to reduced staffing etc.

Given that more than half of the mortgage industry (Brokers and Bankers) are working from home, allow 30 to 45 days minimum for purchases to close.

Anyone who wants to switch lenders and has a maturity date (renewal date) in the next ~30-40 days closing should get confirmation in writing that the new lender can close that quick. If there’s any doubt, ask your existing lender to renew you into an open mortgage, if possible.

Crystal Ball

I don’t know about yours, but my crystal ball appears to be faulty over the last two weeks. Each day it shows me a different future.

We are in uncharted waters. National economies world-wide are more interconnected than ever. There are more moving parts than ever before.

Liquidity is the big risk issue over the mid and long term. The risk is whether or not it is manageable. Some pundits think it will eventually prove to NOT be manageable, that the BoC, CMHC and the federal government will run out of capacity to provide liquidity.

We have been in an ultra-low interest rate environment for over a decade now. Many in the financial world have been predicting for several years an interest rate rise. Some base this in part on the growing under-funded pension liabilities created by such low rates for so long. John Mauldin is one of those.

No-one knows where interest rates are going in the longer term. Rest assured they will go up and they will go down, but we don’t know when or in what order.

I think we are beginning to see the amazing ingenuity and creativity that many people employ when the chips are down, and that makes me believe we will find our way through this without wide-scale destruction of our developed economies. Having said that, the risk is that if this goes very badly, it could well be worse than the 1930’s.

What are we to do?

Cash is King, so preserve your cash as best you can. Take all available payment and other deferrals that you can get. Preserve available capital in your HELOCs and PLC’s.

Some people I know believe banks will selectively lower PLC limits or cancel some altogether. They go so far as to recommend you should take 75% of cash available in your PLCs now and put that money in an account at a different bank.

If you want a home equity line of credit, apply yesterday. Recessions are not conducive to getting great deals on HELOC rates, but again, cash is king. And once you are out of work a HELOC will be more difficult to qualify for, notwithstanding the excellent suite of supports from various levels of government.

If you get a 5-year fixed rate, try to pick a lender with a fair interest rate differential penalty (aka Monoline lender). The big-6 banks’ IRD penalties are on average roughly 2.5 to 3 times higher.

For those who believe Prime will stay low and that Fixed rates will not climb much above current rates, a Variable rate mortgage may be the way to go until the Fixed rates market settles somewhat and those rates drop back down so you lock in.

If you are truly concerned about, or if your financial stability is vulnerable to, interest rise shock, consider a 7-year or a 10-year term fixed rate mortgage. I have seen 7- year and 10-year rates as low as 0.6% to 1.0% above the 5-year Fixed rates recently.

Note- These low long term rates tells us the some of the institutional lenders believe rates will indeed remain low for 7-10 years.

Protect yourself in all your income and debt management decisions, and whatever you do, do it as fast as you can reasonably do it, and based on your risk tolerance. The less tolerance you have the more protective you should be.

As Dr. Cooper writes below this is a time of enormous change and challenge. Yet I find myself surprised and pleased with the responses from our federal government, and from the Alberta government, as well as several other Provinces and Municipalities. The programs announced as of March 29 are breath-taking in scope and breadth. We are going to make it through this, but in the meantime there will likely continue to be swings in mortgage interest rates, both up and down. In another post today I will explore what is happening, why and what I think we should do.

Over the past month, the Bank of Canada has lowered its overnight rate by a whopping 1.5 percentage points to a mere 0.25%. Many people expected mortgage rates to fall equivalently. The banks have reduced prime rates by the full 150 basis points (bps). But, since the second Bank of Canada rate cut on March 13, banks and other lenders have hiked mortgage rates for fixed- and variable-rate loans. That’s not what happens typically when the Bank cuts its overnight rate. But these are extraordinary times.

The Covid-19 pandemic has disrupted everything, shutting down the entire global economy and damaging business and consumer confidence. No one knows when it will end. This degree of uncertainty and the risk to our health is profoundly unnerving.

Aside from one’s own personal sense of obligations to those in need, I believe that society as a whole bears the obligation to help those in need, at all times, and most especially in extraordinarily challenging times.

At this time a very great many Canadians are in need. The Federal & Provincial governments are honouring society’s obligations by way of the many and growing supports, now at a point where it appears that no-one is at risk of not being able to pay for food and shelter and medical costs.

Governments leaned on the banks to provide payment deferrals to Canadians, and to support that are providing liquidity to those banks to allow the banks to do what the federal government has asked. This is an extension of the governments providing the obligated supports to Canadians in need.

Landlords taking deferrals does not deprive Canadian homeowners of their own opportunities to take deferrals. The banks won’t run out of capacity to offer deferrals because the federal Gov’t won’t allow that to happen. Through all this we will stand by our (mostly long-term) tenants and support them and provide information and advice on the programs and benefits as they work their way through this.

The rules Premier Kenney announced on March 27 are essentially what we believe we and our tenants should do. And we’ve conveyed that to our tenants.

Having thought through all that last week, we prefer to take most or all of the mortgage payment deferrals we can to buttress our cash reserves. Once we are through this if we have extra cash remaining we will use it to pay down HELOC debt on our rentals. Why? Because that interest rate is higher than the rate on our mortgages.

If we were in acquisition mode (we aren’t) we would use any such funds towards purchases.

Important note re Income Tax:

Notwithstanding the tax impact of reduced rent income, we must remember that mortgage interest is a tax deductible expense. Hence, mortgage interest deferred within a tax year will reduce taxable income, meaning income taxes owing will be higher. Bottom line: expect roughly a 40% tax on every dollar of mortgage interest deferred in 2020.

In Closing

In just two months this has already become:

The single largest economic disruption and jobs crisis since the great depression

The most concentrated national efforts against a crisis since World War 11 since the Great Depression of the 1030’s

All of which is being driven by the biggest health emergency the world has seen since the Spanish Flu epidemic of 1918-1919.

So what are we to do?

Cash is King, so preserve your cash as best you can. Take all available payment and other deferrals that you can get. Preserve available capital in your HELOCs and PLC’s.

Protect yourself in all your income and debt management decisions, and whatever you do, do it as fast as you can reasonably do it, and based on your risk tolerance. The less tolerance you have the more protective you should be.